By Nick Taborek
Automatic federal budget cuts were supposed to shake the fortunes of Pentagon contractors, with a leading industry lobbyist predicting an “unemployment Armageddon” for defense workers.
Instead, the shares of top U.S. weapons makers Lockheed Martin and Northrop Grumman have rallied. A Bloomberg index of the top 10 defense contractors has gained 5.3 percent since across-the-board spending reductions began March 1, compared with a 1.5 percent increase in the Standard & Poor’s 500 Index over the same period.
That performance belies more than a year’s worth of predictions about the dire consequences of the budget cuts known as sequestration. Former defense secretary Leon E. Panetta said the reductions would render the United States a “paper tiger.” Marion Blakey, head of the Arlington-based Aerospace Industries Association, the biggest defense industry advocacy group, estimated that more than 2 million jobs would disappear in 2013.
Investors may have concluded Pentagon proponents “overstated their case,” said Christopher Preble, vice president of defense and foreign-policy studies at Washington-based Cato Institute, which advocates for limited government. “The defense industry is still doing quite well relative to where they were a decade ago.”
Under the stopgap measure signed by President Obama last month, the Pentagon will lose $41 billion in program funding because of the automatic cuts in the fiscal year that ends Sept. 30. Defense programs would lose about $500 billion over the next nine years if the automatic cuts remain in place.
Investors snapping up defense shares may be too dismissive about that long-term budget pressure, said Brian Ruttenbur, an analyst with CRT Capital Group. Big weapons programs will inevitably be cut over that decade of retrenchment, he said.
“There’s going to be a revision downward across the board, and no one’s even talking about that,” Ruttenbur, who is based in Stamford, Conn., said in a phone interview. “People are pricing in that the Republicans are going to take dramatic tax increases in order to save defense, and I just don’t know if that’s going to be the case.”
Ruttenbur has sell ratings on General Dynamics and Northrop Grumman. He rates Lockheed fairly valued.
The defense rally has taken place even though none of the top weapons-makers considered the automatic cuts into their earnings forecast for this year. The top five defense firms, including Boeing, report first-quarter results this week.
The index of top defense firms includes Huntington Ingalls Industries, the Navy’s sole builder of aircraft carriers, which has advanced 4.6 percent since March 1. The company, which operates a shipyard in Newport News, Va., received a $2.6 billion contract for an upgrade of the USS Abraham Lincoln aircraft carrier last month.
Beci Brenton, a spokeswoman for Huntington Ingalls, said in an e-mail that “most of our work for several years is already under contract,” so near-term effects of sequestration on the company “would be minimal.”
Some investors are optimistic because reductions aren’t likely to substantially affect the top contractors’ financial results until next year, Howard Rubel, an analyst at Jefferies in New York, said in a telephone interview.
Investors believe defense companies’ cash flows will remain strong and most major weapons programs will be spared, said Rubel, who recommends buying shares of top missile supplier Raytheon, nuclear submarine manufacturer General Dynamics and Global Hawk drone-maker Northrop Grumman.
The automatic reductions may be scaled back as part of an agreement between Democrats and Republicans to raise the nation’s debt ceiling this year, Rubel said. Congress will have to increase the borrowing limit this summer to avoid the first U.S. default in history.
Since March 1, announced job losses at the top five defense contractors included 200 positions at Raytheon and 1,160 at Boeing’s commercial unit, according to data compiled by Bloomberg.
The spending deal passed by Congress gave the Pentagon more flexibility in applying program cuts and reduced the number of unpaid workdays imposed on the department’s 800,000 civilian workers to as many as 14 days from 22.
Blakey, chief executive of the Aerospace Industries Association and a leader in the lobbying effort against the sequestration process, told a Washington audience in December that trimming defense spending would reverse the country’s economic fortunes.
“Here’s what we’re facing under year one of sequestration: the loss of 2.14 million jobs, GDP reduced by $215 billion, a 1.5 percent uptick in the unemployment rate and the risk of turning the U.S. economy back into a recession,” Blakey said, according to her prepared remarks.
Bethesda-based Lockheed, whose then-chief executive Robert Stevens in July warned the cuts could lead to the loss of 10,000 jobs, has advanced 7.8 percent since March 1.
Lockheed, the world’s No. 1 defense contractor, still doesn’t know “exactly how our employees or many of our programs will be affected” by the required cuts, Jennifer Allen, a company spokeswoman, said in an e-mail.
Defense stocks gained after Obama on April 10 released a fiscal 2014 spending plan that ignores the automatic cuts mandated by law, giving the Pentagon about $51 billion more to spend next year. The president’s budget also included tax increases that congressional Republicans oppose, rendering the document dead on arrival.
It’s “misplaced optimism” to assume the Defense Department will receive funding at the levels contained in the president’s budget, Byron Callan, a defense analyst at Capital Alpha Partners in Washington, said in a phone interview.
For top defense firms that haven’t suffered from the automatic cuts so far, “there will be an impact but it will be over a longer period of time,” Callan said. “The sequestration numbers are too big to ignore. They absolutely will impact these companies.”